Commentary Directory

The ECB Prepares to Address Excess Liquidity Through the MRR

Jacob Hess
September 26, 2023

The European Central Bank (ECB) is actively exploring methods to curtail the excess liquidity within the euro area banking system. Among the strategies under consideration is a potential adjustment to the minimum reserve requirements ratio (MRR). Such an adjustment could see the MRR rise from its current 1% to either 3% or 4%. In monetary terms, this translates to an escalation in capital requirements from €165 billion to a staggering €500 billion or even €600 billion. A move of this magnitude would exert considerable pressure on bank profitability, primarily because it would limit the volume of funds on which banks can accrue interest within the ECB's deposit facility.

From ECB

As the potential for this change in capital requirements is discussed by the media and analysts, ECB President Lagarde addressed the issue of excess liquidity in her speech in front of the Committee on Economic and Monetary Affairs of the European Parliament. She points out that a lot of excess liquidity has already been drained out of the economy (about €1 trillion) over the past year through the repayments of TLTRO III and the drawdown in securities held under the asset purchase programme (APP). She also shares that the “Eurosystem staff is analysing the optimal long-run size and composition of our balance sheet – and by implication, the adequate level of excess liquidity” which is likely a nod to the suspicions that the MRR is in the ECB’s target. The message seems clear here that there will be a general effort by the ECB to address excess liquidity concerns in the near future. She asserts that “this is not a trivial issue as it has implications for the way we implement monetary policy.”

A more general concern about an MRR hike is that the banking sector may be too fragile to just absorb the damage. As we saw during the banking crises earlier this year, balance sheets were quite vulnerable to major shifts in rates and liquidity that hadn’t been seen in decades. An overreaction by financial institutions to the further withdrawal of excess liquidity could accelerate a hard landing into a panic and a crash. Thus, it is crucial that the ECB walk a fine line here. Communication of potential policy changes has always been key, and it explains why three ECB officials have made speeches in the last two days including Lagarde’s direct mention of “excess liquidity.”